Food Processing Firms, Input Quality Upgrading and Trade

In this paper the heterogeneous firms and trade literature is extended by integrating quality of inputs and outputs in a food and agricultural setting. Recently, Sexton (2013) has suggested that intermediate agricultural input quality is critical in food processing firms’ output quality and pricing decisions. The results presented in this paper indicate that intermediate agricultural input quality, when combined with the quality of other food processing inputs, is important in analyzing the production decision-making of firms. Extending the model of Kugler and Verhoogen (2012), the quality of food processing inputs is integrated into the analysis in two ways: first, it affects the production of the final good, in that higher quality food processing inputs lower the marginal cost of producing the final good; and, second, food processing input quality is complementary to intermediate input quality in determining quality of the final good. By choosing these elements, firms become differentiated on a vertical (quality) level not only because of their capability draw and intermediate input quality choice, but also because of their choice of food processing inputs. Three key results are developed in the paper: first, larger firms, measured by revenue, charge a higher price for their final good, pay a higher price for their inputs, and produce a higher quality final good. Second, firms that produce for export destinations with a higher preference for quality, choose higher-quality inputs. Third, if preference for quality increases in export-destinations new firms enter the export market, while less capable firms are forced to exit.